Activity-Based-Costing (ABC)

List of Contents

1. Introduction

2. Emergence of ABC

3. Evolvement of ABC

4. Impacts of ABC, ABB, and ABM

5. Conclusion

6. References

7. Appendices

1. Introduction

Activity Based Costing, short ABC, was developed in the 1980s as it became apparent that the traditional management accounting practices could no longer meet the arising requirements due to a dramatically changing environment.

Therefore, to detect this way towards ABC, this report will start to look at the book “Relevance Lost: The Rise and Fall of Management Accounting” of Johnson and Kaplan, where they introduce ABC as a recommendation to overcome the shortcomings of the traditional accounting method.

In the subsequent passages of this paper, it is examined how the initial ABC proposed by Johnson and Kaplan has been criticised and expanded. Several impacts on organisations of ABC and its later developments into ABM and ABB are then reported. And finally, all findings will be summarised and it is discussed whether the original criticisms of traditional management accounting techniques really have been outperformed.

2. Emergence of ABC

In the book “Relevance Lost”, Johnson and Kaplan argue that the increasingly changing environment especially in the 1980s with worldwide competition, and enormous advances in technologies (1987, p.3), and more complexity in product lines led to cost systems that ”are helpful neither for product costing nor for operational cost control; they do not provide information useful for cost management” (J&K 1987, p.195).

There is a predominance of financial cost systems that means: simple, arbitrary allocations of overheads to cost centres and then to products. This takes place with the help of estimated direct labour rates. These, due to increasing automations, are up to twenty times higher than the “actual direct labor rate paid to workers” (J&K 1987, p.184) and encourage cost reductions not of overheads that actually cause the high product costs, but regarding the labour costs, though amounting “only 4% of total costs”, (J&K 1987, p.188).

Since 1925 almost all management accounting techniques have been introduced, but no further innovations were undertaken to pay regard to the changing environment (J&K 1987, p.12).

Resulting problems of current cost systems are distortion of product costs as well as “delayed and overly aggregated” information (J&K 1987, p.13).

Thus, to avoid these deficits of traditional cost systems, Johnson and Kaplan make recommendations on how relevant cost information can be attained for process control and product costs calculations.

Process control

Processes of different organisational departments, or ‘cost centres’ can be controlled through ‘flexible budgets’ that “compare actual to budgeted [costs] and investigate any significant variances” (J&K 1987, p.231). To obtain these costs, ‘cost drivers’^[1] that lead to varying costs, and the periodicity of producing measurable units must be identified because for “operations turning out multiple parts per second, it is not helpful to have a monthly cost control report” (J&K 1987, pp.229,230).

Product Costs

Product costs must be computed referring to the time horizon and type of problem that is expected to solve.

Short-term product costs are utilised for decisions that emerge in the short-run like: adjusting the product mix or whether or not accepting orders received, and include all variable costs as well as opportunity costs (J&K 1987, pp.233,234).

In contrast, long-term product costs take into account all, variable and fixed costs. For decisions concerning “product pricing, product abandonment […], and make or buy” (J&K 1987, p.233), all costs become variable and controllable due to the long time horizon.

The calculation of long-term product costs differs enormously from traditional cost systems. (J&K 1987, p.234)

The ‘cost tracing process’ begins at the ‘component level’: For each component the demand on cost drivers must be identified. The total cost of each cost driver is, then, divided by the total number of cost drivers demanded by diverse components, and results in the ‘cost per driver’.

To calculate the costs of single components, in a second step, the numbers of each cost driver used by a certain component are each multiplied with the cost per driver (computed above). All results for different cost drivers build the cost of a single component.

Knowing the component costs, product costs can be calculated. (J&K 1987, pp.238,239)

As previously mentioned, all costs including costs outside the factory, like marketing and distribution must be considered and traced as described (J&K 1987, pp.244-247).

In doing so, unprofitable products can be identified. To realise cost savings, products have to be repriced, produced more efficiently e.g. with common parts, or when eliminated, resources freed should be abandoned. (J&K 1987, pp.239,240)

After all, Johnson and Kaplan (1987, pp.248-251) advocate the establishment of three different cost systems: One for period costs based on financial reporting requirements^[2], a second for process control and a third for product costing. This differentiation is justified with diverse time frames, allocation methods, and audiences of those systems.

3. Evolvement of ABC

Introducing the first approach of ABC already shows advantages: Overheads of many cost pools are allocated with the help of appropriate cost drivers that are not only based on the output volume. Thus, costs are more accurately allocated to single products considering their individual activity requirements. In this way, e.g. low-volume products are often more expensive due to its costs that cannot be traced arbitrary to all other products. Furthermore, non-factory costs like marketing and distribution are assigned to products, too.

However, the view that virtually all costs are variable and should be allocated to products requires some adjustments.

In 1988, Cooper and Kaplan (pp.102, 103) point out that excess capacity as well as research and development costs for absolutely new products should not be allocated to existing products.

Another revision came, when Cooper and Kaplan (1991) introduced the “ABC Hierarchy”:

Abbildung in dieser Leseprobe nicht enthalten

(C&K 1991, p.132)^[3]

The hierarchy distinguishes:

- costs of facility- and product-sustaining activities that are not allocated to single products, but rather to product lines or whole institutions;
- batch-level activities that relate to a certain number of products;
- unit-level activities which costs are directly traced to single products.

In this manner, managers cannot be misled to think that e.g. costs like setups or product engineering do vary with the output produced. They only change in steps that have to be uncovered to make effective decisions. (C&K 1991, p.132)

[...]

^[1] Next to the common direct labour hours, now also non-volume based cost drivers like number of set-ups, or orders received were included that do not depend on the output produced.

^[2] For financial reports it is necessary to valuate the inventory and the costs of products sold. (J&K 1987, p.234)

^[3] This hierarchy can be applied throughout a company i.e. for accurate cost allocations for all kinds of “products, brands, customers, facilities, regions, or distributions channels” (C&K 1991, p.130).